During periods of major economic duress, escaping the financial markets entirely (or re-positioning to profit from falling asset prices) can be wise. At other times, during less intense periods of duress, seeking exposure that has thermos-like insulation from outside forces may be the way to go.
If you haven't noticed, most of the concerns plaguing the global economy are not native to the U.S.. We've got oil exporting nations hurting from lower oil prices, Greece causing concerns over a possible default or withdrawal from the European Union, China fighting to restructure their economy and abate slowing growth, and a host of countries experiencing disinflation/deflation and on the verge of recession. The U.S. however, and the U.S. consumer, seem to be doing fine (relatively speaking).
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That being the case, where can investors find solace among all these sources of risk and volatility? Perhaps in small-cap domestic stocks. Even though small-caps, evidenced by the Russell 2000, haven't gone anywhere in the last year, we are seeing some indications of renewed enthusiasm.
Take a look at the chart below, which shows the relative strength between the Russell 2000 and the broader S&P 500. We can see that a major shift occurred in October as a long period of declining highs and lows transitioned to one of rising highs and lows. What's causing this?
As alluded to above, small-caps may present a haven for equity investors who are trying to get as far away from international tensions as possible.
Small-cap companies are more resilient to conditions abroad because a much higher percentage of their sales are domestic. Data from Bank of America Merrill Lynch suggests that 81% of revenues for Russell 2000 companies come from U.S.. This compares with 65% of revenues for large-cap firms. Said differently, small-cap companies have 19% of their sales exposure at risk from deteriorating conditions overseas, while large cap companies have nearly twice that (35%).
The implications of a rising dollar also favor small-caps for the same reason: a higher percentage of domestic sales. A rising dollar exchange rate relative to other currencies doesn't matter if the bulk of your customers are dollar-based.
If there has been one major theme permeating Q4 earnings calls from major multinational firms, it's that dollar strength is hurting their sales. And this may not be a short-lived phenomenon. With the U.S. economy and U.S. markets much stronger than those of Europe and Asia, and diverging paths of monetary policy funneling capital towards the U.S., continued dollar strength is very likely.
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U.S. consumers, on the other hand, are benefiting from a host of tailwinds. With more people employed every day and wages showing subtle signs of strength, the propensity for American consumers to spend is rising. Positive traction in labor markets is boosting consumer confidence, allowing them to feel more comfortable with their purchases. Lower gasoline prices are also helping keep more capital in the U.S., and this increase in wealth is accruing directly to consumers. Finally, a stronger dollar is making international goods and travel cheaper and is helping to keep inflation benign and the Fed accommodative.
Since our primary concern in owning stocks is the profitability of those companies, why not focus on those in the sweet-spot, who primarily serve customers that are growing healthier by the day?
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There is a chart pattern that may also suggest higher prices for small-caps ahead. Below is a monthly chart of the Russell 2000. From this perspective we can see a flag pattern developing. Flag patterns occur when a sharp price movement is followed by a period of sideways price movement. The sharp rise is considered the flag pole and the period of sideways consolidation is the flag. These formations are generally viewed as continuation patterns, in which the subsequent breakout from consolidation should be in the direction of the initial move.
This suggests that if the Russell 2000 is able to rise above the trendline that marked resistance for nearly all of 2014, higher prices may lay ahead. As you can see in the chart, we have been pressing up against that upper trendline for the past few months.
The following was an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
